OPM, COST OF CAPITAL AND THE FIRM

The introduction and exploitation of new ideas, the source of all major growth, requires considerable capital investment. Consequently, the degree to which an organization will develop is highly dependent upon its ability to marshal and direct a consistent flow of external funds towards the development and marketing of new products and services. This is the concept of using OPM (Other Peoples Money).

The Pecking order theory of financial management states that all things being equal, a company with high prospects of success is more likely to finance its investment projects using internally generated capital, followed by debt finance (mortgages, debentures), and finally equity based financing (common stock, preferred stock). This is premised on the view that the company would be able to generate sufficient income from the project to refund the monies borrowed and the interest thereon.

However the ability of a firm to invest in new projects is directly tied to its cost of capital; that is, the interest rate at which the organization may raise finance from a bank or financial entity. As a general rule, the higher the risk free interest rate, which is the interest rate at which 3-Month Treasury Bills are sold in the money market, the higher the cost of capital within the economy.

Look at it this way, if a bank could receive a sure return of 10% per annum by investing its funds in Treasury bills, wouldn’t it require a higher rate of return from a prospective borrower who presents a substantially riskier project? Banks are assumed to be risk averse, and consequently they are likely to penalize borrowers for each additional unit of risk in the form of increased interest rates.

Money is expensive and when we look at balance sheets of Nigerian companies it becomes readily evident that the cost of loans is a growing problem. A high cost of capital has the effect of stifling innovation and often leads to capital flight and domestic unemployment, as companies seek greener economies with more favourable costs of capital.

Fortunately, alternative means of finance presently exist which seek to circumvent the high costs of capital imposed by banks (who by the way need to finance their high overheads by charging high interest rates on loans to customers). These means include Peer to Peer Business lending, SME financing programs (especially for entrepreneurs in the agricultural space), Soft loans and Business support grants from non governmental organizations. Furthermore, most states have in place business empowerment programs which provide low interest finance to entrepreneurs who have viable business plans.

The concept of using OPM still exists, but unless management can objectively justify the assumption of debt, it is advisable that the use of debt financing be minimized whensoever Treasury bill yields are high. It is also advisable that firms invest in Capital projects designed to boost its revenue base, as opposed to revenue expenditure, which only serves to deplete the organization’s capital base.

If you feel you need to discuss options for capitalisation of your business, feel free to discuss with one of our consultants by calling +2348036258312 or send and email to miltoncrosslexng@gmail.com and someone will get back to you.

Leave a Reply

Your email address will not be published.